A mutual fund is an investment company that invests in a diversified portfolio of securities. Investors who buy shares of a mutual fund are its owners or shareholders. Their investments provide the money for a mutual fund to buy securities such as stocks and bonds. Funds must calculate the price of their shares every business day. Investors can sell some or all of their shares anytime and receive the current share price, which may be more or less than the price originally paid. The share price is the market value of all the fund's assets (primarily securities), minus liabilities (the net asset value or NAV), divided by the total number of shares outstanding. The NAV and share price change as the values of the underlying securities rise or fall, and as the fund changes its portfolio by buying new securities or selling existing ones.
All funds have fees and expenses that are paid by investors and shareholders. The charges or sales commissions paid to buy, sell or exchange shares of a fund (“shareholder fees”), plus the annual costs paid directly by the fund that are associated with operating the fund (“annual fund operating expenses”), will affect shareholders' return on their investment in a fund.
A common type of shareholder fee is the sales charge or “load”, which may be paid to the financial intermediary involved in the transaction. These “loads” may take the form of charges when an investor buys shares (“front-end loads”) or sells shares (“back-end loads” or contingent deferred sales charges). Funds may also be structured as “no-load” with no sales charge, which are intended for investors who make their own investment decisions, usually without the advice of a financial professional. Although no-load funds do not charge a fee to buy, sell, or exchange shares, they may have an annual distribution (12b-1) or service fee to compensate sales professionals for providing ongoing services.
Annual fund operating expenses reflect the normal costs of operating a fund. These fees include such things as management and administration fees, distribution (12b-1) fees and shareholder servicing fees, and other expenses. Rule 12b-1 fees authorize funds to pay for marketing and distribution expenses, such as compensating sales professionals, directly from a fund's assets.
Because investors have different needs, funds may offer different pricing arrangements in the form of “classes” of shares. Share classes represent ownership in the same fund but offer investors a choice in how to pay for the fund. For example, a fund may offer Class A, Class B, and Class C shares. A typical construction of this structure follows:                Class A shares: front-end load and no, or a low, 12b-1 fee.        Class B shares: no front-end load, but a back-end load if shares are sold before a certain number of years, and a higher 12b-1 fee. After a period of years, B shares convert to A shares.        Class C shares: a higher 12b-1 fee, and lower or no front-end or back-end loads.                    This class of shares typically will not convert to A shares.                        
Funds may offer additional classes. Class A shares are generally structured to include “Rights of Accumulation” or “ROA”, which entitles investors to a discounted front-end sales load for larger investments, typically provided at set breakpoints. For example, a fund with a five percent (5%) front-end sales load may offer a breakpoint at $50,000, such that if an investor purchases more than $50,000 worth of fund shares s/he will pay a lower front-end sales load, perhaps four percent (4%). Class A share breakpoint schedules typically are structured such that investors who invest a significant sum, e.g., $1,000,000, will pay no (0%) front-end sales load. For investors paying a front-end sales load, the effect is that, initially, something less than their total investment in the fund is actually invested in the fund. For example, an investor purchasing $10,000 worth of shares in a fund with a five percent (5%) front-end sales load is actually investing only $9,500 in the fund (with the remaining $500 being paid to the financial advisor or broker). If after one year, the fund appreciates in value by 5%, the value of the shareholders investment, based on the $9,500 investment, is $9,975.
Class B shares were offered, in part, as a response to certain shareholders' desire for an investment option without a front-end load, where the investor would see the total value of their initial investment invested in shares of the fund. Instead of paying a front-end load, an investor in Class B shares paid higher ongoing annual fees, typically in the form of a higher distribution (12b-1) fee, and was assessed a back-end load if and when s/he sold their shares. Back-end loads were typically structured on a declining scale such that, after a period of years, the back-end load would be decreased to zero, and eventually the B shares would be converted to A shares. This conversion to A shares is beneficial to the shareholder because of the lower ongoing distribution (12b-1) fees. Class C shares were another attempt to satisfy the desire of investors not to pay, or to limit, the front-end sales load. Class C shares are therefore typically structured with a low front-end sales load or no front-end sales load, and a shorter term, low, back-end sales load; C shares also bear a higher ongoing distribution (12b-1) fee, and are not typically converted to A shares.
These alternative share classes have encountered their share of criticism. For example, although it may be appealing to an investor not to pay a front-end sales load, and therefore to invest in B shares, the investor may be better off in A shares because of ROA or lower ongoing 12b-1 fees. Some funds have responded to these criticisms by closing B shares to new investors or limiting how much an investor can invest in B shares. Class C shares have encountered similar criticisms insofar as C shares never convert to A shares, i.e., for as long as a shareholder owns C shares, s/he will pay higher annual fees.
For a financial intermediary recommending a fund, or for an investor purchasing a fund, determining which share class may be best is complicated by several factors including but not limited to issues such as how much the investor is investing, over what time horizon the investor will be investing, how much and in what structure commissions will paid to the financial advisor or broker, and other considerations.
While many other classes of mutual fund shares have been created, none have gained in popularity and the other classes are generally directed to specific and narrow investment purposes. Thus, a need exists for mutual fund shares that offer an alternative cost structure, yet overcomes the abovementioned criticisms.